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Aug 27, 2018

Introducing Options on Futures

By:Sage Anderson

Today on the blog, we're introducing options on futures, which should be relatively easy for most tastytraders to digest, especially because most will already be aware of both options and futures as independent securities.

The principle behind options on futures is effectively a combination of the two, much like the name implies.

For most traders, the term "option" likely conjures a traditional equity option, which uses an equity for the underlying. Options on futures are quite similar, except they use futures as the underlying.

Just as traders can choose from a large number of underlyings when trading options, there is a large pool of futures products to choose from when trading options on futures. As noted on a previous piece highlighting the futures market, there are six main categories that futures are typically grouped in: agricultural, energy, metals, equity index, foreign exchange, and interest rates.

As with equity options, traders need to be careful when selecting the underlying and month to ensure they are trading the intended underlyings. Equity options typically offer multiple contract months for the same underlying, and traders can select short-term, medium-term, or longer-term maturities. Futures contracts also offer a range of expiration choices, as well as associated options.

Generally speaking, options on futures contracts are traded on the same exchange where the original futures contracts are traded.

You’ll find that the “official” definition for an option on a future is also quite similar to an equity option - an option on a futures contract gives the holder the right, but not the obligation, to buy or sell a specific futures contract at a specific price on or before the option's expiration date.

That means that for call options the contract owner enters the long side of the futures underlying (or cash) at the strike price, upon exercise. For put options, the owner the option owner enters the short side of the futures underlying (or cash) at the strike price, upon exercise.

The cash settlement aspect of options on futures is slightly different than what is observed in equity options. In general, if a futures option has the same expiration month as the future itself, then the contract settles into cash. If the options and futures expire in different months, then the options contract will settle into futures.

As with equity options, traders also need to understand the specifications for a given option on a futures contract as they will vary across products. For options on equities, the contract multiplier is 100 (100 shares per contract) and the minimum tick is usually $0.01. $0.05, or $0.10.

The contract multiplier and minimum tick vary across products when dealing with options on futures. A previous installment of Closing the Gap - Futures Edition provides a detailed breakdown of several examples (/ES, /CL, /ZB, /6E), as shown in the graphic below:

While the above may “look like Greek to me,” it was probably the same the first time you dealt with traditional equity options. Getting a handle on the contract multipliers and minimum tick sizes for the various options on futures products simply takes a little time.

Mock trading options on futures, as with any unfamiliar security, can be a great way of gaining experience without the pain of potential losses.

Before getting started, we also recommend reviewing some previous tastytrade programming which focuses specifically on futures options:

As with any possible addition to your portfolio, the most important thing is to ensure that a product is suitable for your risk profile and strategic approach to the financial markets.

Many of the skills you’ve likely already developed trading traditional options should also assist you as you dive into other products. For example, seeking an adequate level of liquidity is important no matter what you are trading. Be aware that liquidity levels can vary significantly across the options on futures universe.

If you have any outstanding questions on this topic, we hope you’ll leave a message in the space below, or reach out directly to support@tastytrade.com.

We look forward to hearing from you!

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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